Collateralized debt obligations (CDOs) are a type of structured credit product in the world of asset-backed securities. The purpose of these products is to create tiered cash flows from mortgages and other debt obligations that ultimately make the entire cost of lending cheaper for the aggregate economy. This happens when the original money lenders give out loans based on less stringent loan requirements. The idea is that if they can break up the pool of debt repayments into streams of investments with different cash flows, there will be a larger group of investors who will be willing to buy in. (For more on why mortgages are sold this way, see Behind The Scenes Of Your Mortgage.)

TUTORIALS: Mortgage Basics

For example, by splitting a pool of bonds or any variation of different loans and credit-based assets that mature in 10 years into multiple classes of securities that mature in one, three, five and 10 years, more investors with different investment horizons will be interested in investing. In this article, we'll go over CDOs and how they function in the financial markets.

For simplicity, this article will focus mostly on mortgages, but CDOs do not solely involve mortgage cash flows. The underlying cash flows in these structures can be comprised of credit receivables, corporate bonds, lines of credit, and almost any debt and instruments. For example, CDOs are similar to the term "subprime", which generally pertains to mortgages, although there are many equivalents in auto loans, credit lines and credit card receivables that are higher risk.

How do CDOs work?

Initially, all the cash flows from a CDO's collection of assets are pooled together. This pool of payments is separated into rated tranches. Each tranche also has a perceived (or stated) debt rating to it. The highest end of the credit spectrum is usually the 'AAA' rated senior tranche. The middle tranches are generally referred to as mezzanine tranches and generally carry 'AA' to 'BB' ratings and the lowest junk or unrated tranches are called the equity tranches. Each specific rating determines how much principal and interest each tranche receives. (Keep reading about tranches in Profit From Mortgage Debt With MBS and What is a tranche?)

The 'AAA'-rated senior tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed payments. As such, it has the most predictable cash flow and is usually deemed to carry the lowest risk. On the other hand, the lowest rated tranches usually only receive principal and interest payments after all other tranches are paid. Furthermore they are also first in line to absorb defaults and late payments. Depending on how spread out the entire CDO structure is and depending on what the loan composition is, the equity tranche can generally become the "toxic waste" portion of the issue.

Note: This is the most basic model of how CDOs are structured. CDOs can literally be structured in almost any manner, so CDO investors can't presume a steady cookie-cutter breakdown. Most CDOs will involve mortgages, although there are many other cash flows from corporate debt or auto receivables that can be included in a CDO structure.

Who Buys CDOs?

Generally speaking, it is rare for John Q. Public to directly own a CDO. Insurance companies, banks, pension funds, investment managers, investment banks and hedge funds are the typical buyers. These institutions look to outperform Treasury yields, and will take what they hope is appropriate risk to outperform Treasury returns. Added risk yields higher returns when the payment environment is normal and when the economy is normal or strong. When things slow or when defaults rise, the flip side is obvious and greater losses occur.

Asset Composition Complications

To make matters a bit more complicated, CDOs can be made up of a collection of prime loans, near prime loans (called Alt.-A loans), risky subprime loans or some combination of the above. These are terms that usually pertain to the mortgage structures. This is because mortgage structures and derivatives related to mortgages have been the most common form of underlying cash flow and assets behind CDOs. (To learn more about the subprime market and its meltdown, see our Subprime Mortgage Meltdown feature.)

If a buyer of a CDO thinks the underlying credit risk is investment grade and the firm is willing to settle for only a slightly higher yield than a Treasury, the issuer would be under more scrutiny if it turns out that the underlying credit is much riskier than the yield would dictate. This surfaced as one of the hidden risks in more complicated CDO structures. The most simple explanation behind this, regardless of a CDO's structure in mortgage, credit card, auto loans, or even corporate debt, would surround the fact that loans have been made and credit has been extended to borrowers that weren't as prime as the lenders thought.

Other Complications

Other than asset composition, other factors can cause CDOs to be more complicated. For starters, some structures use leverage and credit derivatives that can trick even the senior tranche out of being deemed safe. These structures can become synthetic CDOs that are backed merely by derivatives and credit default swaps made between lenders and in the derivative markets. Many CDOs get structured such that the underlying collateral is cash flows from other CDOs, and these become leveraged structures. This increases the level of risk because the analysis of the underlying collateral (the loans) may not yield anything other than basic information found in the prospectus. Care must be taken regarding how these CDOs are structured, because if enough debt defaults or debts are prepaid too quickly, the payment structure on the prospective cash flows will not hold and the some tranche holders will not receive their designated cash flows. Adding leverage to the equation will magnify any and all effects if an incorrect assumption is made.

The simplest CDO is a 'single structure CDO'. These pose less risk because they are usually based solely on one group of underlying loans. It makes the analysis straightforward because it is easy to determine what the cash flows and defaults look like.

Are CDOs Justified, or Funny Money?

As mentioned before, the existence of these debt obligations is to make the aggregate loaning process cheaper to the economy. The other reason is that there is a willing market of investors who are willing to buy tranches or cash flows in what they believe will yield a higher return to their fixed income and credit portfolios than Treasury bills and notes with the same implied maturity schedule.

Unfortunately, there can be a huge discrepancy between perceived risks and actual risks in investing. Many buyers of this product are complacent after purchasing the structures enough times to believe they will always hold up and everything will perform as expected. But when the credit blow-ups happen, there is very little recourse. If credit losses choke off borrowing and you are one of the top 10 largest buyers of the more toxic structures out there, then you face a large dilemma when you have to get out or pare down. In extreme cases, some buyers face the "NO BID" scenario, in which there is no buyer and calculating a value is impossible. This creates major problems for regulated and reporting financial institutions. This aspect pertains to any CDO regardless of whether the underlying cash flows come from mortgages, corporate debt, or any form of consumer loan structure.

Will CDOs Ever Disappear?

Regardless of what occurs in the economy, CDOs are likely to exist in some form or fashion, because the alternative can be problematic. If loans cannot be carved up into tranches the end result will be tighter credit markets with higher borrowing rates.

This boils down to the notion that firms are able to sell different cash flow streams to different types of investors. So, if a cash flow stream cannot be customized to numerous types of investors, then the pool of end product buyers will naturally be far smaller. In effect, this will shrink the traditional group of buyers down to insurance companies and pension funds that have much longer-term outlooks than banks and other financial institutions that can only invest with a three- to five-year horizon.

The Bottom Line 

As long as there is a pool of borrowers and lenders out there, you will find financial institutions that are willing to take risk on parts of the cash flows. Each new decade is likely to bring out new structured products, with new challenges for investors and the markets.